Why China’s growth could be over

Independent analyses by both the University of California macroeconomist James Hamilton and the Bank of England have fingered weak demand as the chief cause of low oil prices. Given that China is the driver of incremental demand for most commodities, weak prices must therefore be principally attributed to weakness in the Chinese economy.

But what sort of weakness is this? The thinking splits two ways. Many analysts anticipate a gradual slowdown in China's underlying growth rate as it migrates from an investment-led to a consumer-led economy. By this view, China is facing a structural re-alignment, with the shift requiring another two to four years. Things are slowing down, but it's nothing serious.

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An investor reacts at a stock exchange hall on January 4, 2016 in Hangzhou, Zhejiang Province of China.

A darker view sees a credit bubble emanating from years of misguided over-investment in China's infrastructure, housing and manufacturing. China has created an unsustainable credit bubble, and this will come crashing down, taking the Chinese—and by implication, East Asian—economy with it. This view does not deny the need to restructure the Chinese economy, but anticipates a cyclical downturn, a financial crisis along the lines of 1998. The Chinese economy will not see a "soft landing," but rather a full-blown crash.

We have proposed the third hypothesis. The collapse of commodity prices from mid-2014 corresponded to an oil supply surge and the failure of China to devalue the yuan in line with the yen, won and euro. By this line of thinking, China made a simple policy mistake which killed its exports, and with it, the incremental demand for commodity imports. Thus, if China devalues, then all should be well and commodity prices should recover about half their losses since summer 2014. If this is true, China is not in such bad shape. All the country needs is a quick, if painful and politically awkward, devaluation.

However, a fourth theory also merits consideration: leadership has taken the country in a new direction, and this is dampening China's growth. From Deng Xiaoping until the current Xi administration, China has been ruled by an economically liberal philosophy emphasizing economic growth, global integration, and harmonious relations with other countries. With the Xi administration, however, the social compact has become conservative. Nationalism, not economic liberalism, now seems the driver of policy decisions.

Other post-communist nations have taken this path already. In Hungary, for example, the Orbán government has repeatedly thumbed its nose at European norms, nationalizing pensions, reducing the independence of the judiciary, decreasing fiscal transparency, and restricting media rights. It has proved popular, with Orbán's FIDESZ party winning a qualified majority in Hungary's 2014 parliamentary elections.

But nationalism comes at a price. Hungary's GDP is barely above its 2005 level, even as those of Poland and Slovakia have soared. From 2005 to 2015, Hungary's GDP growth averaged 0.8 percent, versus 3.4 percent for Slovakia and 3.9 percent for Poland. Not all of this is due to the Orbán regime, which took power in 2010. But the Orbán government has exacerbated a turn inward which had started in the early 2000s. As such, Orbán is both a cause and effect of rising Hungarian nationalism. The resulting policies have knocked nearly 3 percentage points from Hungary's GDP growth annually.

How would comparable policies affect China? If China followed Hungary's script, China's growth rate would decline from the desired 7 percent to around 3-4 percent, about $300 billion per year in foregone GDP growth. Interestingly, this puts China's GDP growth on the level recently estimated by a number of independent consultancies. Thus, the impacts of a switchover to a nationalist ideology may already be manifest in the Chinese economy.

The question, however, is whether an economy accustomed to growing above 7 percent—and leveraged accordingly—can be decelerated to a lower growth rate without prompting an outright recession. Some think a recession is inevitable. For example, Tyler Cowen, professor of economics at George Mason University, believes China's GDP is "headed rapidly to zero." He is often right in these matters.

On top of generally reduced growth prospects, nationalism can lead to specific territorial conflicts which have distinct economic impacts. Both Russia and China have adopted acquisitive and confrontational policies regarding territorial claims. Russia has annexed Crimea, and China is pressing territorial claims in the South China Sea by building a military base at Fiery Cross Reef.

Such moves are invariably popular domestically, at least in the beginning. In Russia, President Vladimir Putin boasts approval ratings approaching 80 percent, even when measured by independent observers. Much of it is due to war. By at least some measures, Putin's approval ratings jumped more than 20 percentage points with Russia's invasion of Crimea. And there is nothing uniquely Russian about this. U.S. President George W. Bush saw his popularity jump 13 percentage points with the start of the Iraq War in 2003.

But wars are expensive. A Brown University study estimates that the Iraq War cost the U.S. taxpayer $1.7 trillion and as much as $2.2 trillion if future costs of veterans' care are included. For Russia, the costs are comparatively steeper. Even discounting the effect of low oil prices, we estimate that sanctions look to reduce Russia's GDP by 17 percent per year, compared to a no sanctions scenario, by 2020. That's phenomenally expensive.

And Putin has no exit strategy. The histories of Cuba,Iran and Saddam Hussein's Iraq show that sanctions remain in place for many years, often decades. Will Putin relinquish Crimea in return for the lifting of sanctions? It would be political suicide on the domestic front. Consequently, Putin can neither advance nor retreat. He has trapped Russia in a sanctions regime—exiled from the family of G7 nations—for not only years, but for decades to come.

China has prepared a similar trap for itself by asserting territorial claims with the building of a base at Fiery Cross Reef—600 miles from the Chinese mainland. Consider: An aircraft flying from Manila to Singapore would transit over Fiery Cross. Were China to shoot down an aircraft on such a path, it could prove the single most expensive aircraft downing ever. Sanctions comparable to those on Russia would cost China $2 trillion per year in foregone GDP. Just how much is Fiery Cross—indeed, the whole South China Sea—worth to the Chinese? For purposes of comparison, the U.S. Gulf of Mexico produces $25 billion of oil and gas revenues per year and is thought superior to the potential of the South China Sea. Put another way, Russian-scale sanctions could equal 100 times the potential gain from the South China Sea. Has Beijing considered this possibility?

And this brings us to the PMIs, the Purchasing Managers' Indices recently suspended in China. These are prepared on a monthly and "flash" basis. The flash numbers are issued early based on a partial sample of business surveys, providing a quick read of economic conditions.

The loss of the flash PMIs is troubling on three fronts.

First, I think most analysts assume that China's leadership has better, more timely and more trustworthy data than is released to the public. Consequently, withholding the PMIs gives the impression that the incoming economic data is much worse than expected—the missing PMIs are themselves leading indicators of a noteworthy economic downturn.

Second, the loss of the PMIs could also reflect a lack of confidence by China's leadership in their ability to manage a downturn. Not only are the incoming data worse than expected, leadership does not know if it can manage the challenge.

Finally, the suppression of the PMIs takes China firmly in the wrong direction, away from progress, development and transparency. It suggests leadership wants to reverse the country's historical course and revert back to a more closed, less dynamic economy. National strength, in the form of centralized decision-making and control, is to be valued over economic progress.

Taken together, these factors suggest the time has arrived to question whether slow growth in China is solely attributable to structural factors. What responsibility does the Xi government bear? We seem to be witnessing error compounding error. An over-valued yuan leads to poor manufacturing numbers, reflected in weak PMI readings, and leading to political pressure to pull the related PMIs. This in turn undermines the credibility of and confidence in the government, prompting a crash of the Chinese stock market.

Moreover, China seems to want to distance itself from the G7 and align its fortunes with poorly managed countries like Russia and Hungary. The country looks headed on a downward spiral, with the government lacking the right stuff to make appropriate adjustments.

Behind it all, I see the marks of a shift to nationalism and away from economic liberalism. "Strong" is preferred to "smart." For a country with comparative advantage in "smart," this looks to be a bad decision. But nationalist policies can persist for a long time. They have in Hungary and Russia, and they have done so with public approval. We'll see how events play out in China, but for now, investors need to consider that the China of the last thirty years may no longer correspond to the China of today — or tomorrow. China's era of growth may be over.